Passive or Active investing is not the only choice in town
Most investors focus on the distinction between passive index investing (just achieving passive beta market returns) and active investing that tries to beat benchmark indexes and generate alpha (above market and benchmark returns).
However, those are not the only choices investors have. We already know that active investing in equities is a difficult game to play with more than 75% of active investors typically underachieving passive market returns.
However, even for passive, it's not as simple as we think. We first need to define what passive actually means. Let's take the US equities market as an example. It has several famous and commonly used indexes such as the S&P 500, the Dow Jones Index and the Russell 3000. However, the S&P 500 is an index of the 500 largest companies in the US, the Dow Jones is in fact a smaller index of just 30 stocks and the Russell 3000 Index is obviously a broader index of 3,000 stocks.
But is that the total US equities market? Nope. The total number of stocks listed in the US stock exchanges is over 4,000 stocks in just the two major exchanges - NYSE and Nasdaq. If you include the other smaller exchanges and other calculation methods that take into account OTC and grey markets, it takes that total to closer to 10,000 stocks. As you can see even what we perceive to be passive is not really as passive as we think.
Also, passive is different from indexing. Indexes can be passive but it's something somebody created to follow a certain subset of the total market. It could be the S&P 500 but it can also be the Tech sector index or the E-commerce or Robotics index which does not give you any broad market exposure it's still indexed and can be called a benchmark for some investors but it's often an active index. The only way to be passive is if we own every listed stock in the exchanges and that will be the broadest measure of ownership. The fund with the broadest exposure in the US would be the famous Vanguard Total Market Index Fund holding a grand total of 3,597 stocks.
Factor-based investment strategies are evidence-based and combine the best of indexing — low cost and broad diversification — with flexible active implementation to emphasise higher expected returns and manage risk.
Factor investing explained
At the heart of factor investing is a question for the ages: why do certain stocks and bonds rise or fall more than the rest? It is a question so deceptively simple but has spurred decades of research to uncover some factors that drive better performance.
Dr Eugene Fama and Ken French discovered in 1992 that three factors explain over 90% of stock returns — those are market returns (we call market beta), size (smaller companies tend to outperform larger companies) and value (cheaper companies tend to outperform more expensive companies). This marked the beginning of factor investing.
Fast forward to today, the endeavour of factor discovery is still ongoing, and there is an expanded set of factors. For stocks, these have expanded into factors such as quality, momentum, and minimum volatility. In the fixed income space, these factors include term and credit. To qualify as an investment factor, the factor needs to be persistent across time, and prevalent in different markets. Usually, there is a risk-based or behaviour-based explanation as to why securities defined by certain characteristics tend to outperform in the long term.
This is why people like to say that factor-based investing is evidence-based. It is based on empirical evidence by studying decades of observations in multiple markets and is fundamentally supported by economic rationales. So while the pursuit of alpha (return above market performance) is exhilarating, partly because no one knows for sure how that alpha is generated, an investment strategy seeking to gain exposure to the market and proven factors of return such as value, size and quality is more assuring to many investors.
Long-term factors used by Dimensional Fund Advisors
Dimensional summarised the essence of systematic factor investing very well: “Systematic (factor) investing typically seeks to outperform markets by structuring investments around factors linked to differences in expected returns. This differentiates systematic investing from traditional indexing, which typically seeks to deliver market returns, and traditional active investing, which may seek outperformance by identifying so-called mispriced securities or timing markets.”
How has factor investing performed?
In the equities market, over the long term, the statistical evidence for the outperformance of small, cheaper and higher quality companies compared with their respective counterparts is overwhelmingly positive in US, developed ex-US and emerging equity markets. This is illustrated in the chart below.
In the fixed income market, the charts below indicate higher average term and credit premiums during months when term and credit spreads are wider. There is a body of academic research that provides support for the reliable relationship between the width of credit and term spread, and the subsequent premiums.
However, those familiar with the value-investment style in equities would know that the past decade from 2010 to 2020 marked a lost decade for the value factor. It was a golden decade for growth stocks: the US was the best performing market and within the US, the blue-chip firms that offered high growth at rich valuations performed the best. The value factor’s underperformance against the growth factor was observed not only in the US but also in the rest of the world. It was a soul-searching decade for value investors, and many were asking the question of whether value is gone.
Is Value coming back?
There has been an ongoing debate in the market on whether the persistently low interest rate environment may have been the culprit for the underperformance of the value factor in the past decade. While there remains no conclusive evidence, those who argued that way may be right.
As the Fed turned increasingly hawkish in 2021, the value factor made a strong comeback. This has continued into 2022. While the overall equity market has been down, growth stocks have led the losses, with value stocks holding up relatively well.
How does Dimensional manage its funds?
On a high level, Dimensional’s process combines the best of indexing, such as broad diversification, low turnover, and transparency, with flexible active implementation to emphasise higher expected returns and manage risk.
It is important to note that, unlike pure factor strategies that narrowly invest in single factors exclusively, Dimensional actually buys the whole liquid, investable market to capture that broad market exposure first. Then, instead of weighting the securities based on market capitalisation, as is done by plain-vanilla index funds, they would weight the securities based on how much exposure it has to the proven factors of expected return. Hence, cheaper, smaller and higher profitability companies get more weightage in equities. In fixed income, they increase duration exposure when the yield curve steepens (as a wider term spread implies a higher term premium) and increase credit exposure when the credit spread widens (as a wider credit spread implies a higher credit premium).
However, the devil is in the details when it comes to factor investing. What really sets Dimensional apart is its sophisticated design, implementation, and risk management process.
Take the equities portfolio for example. The decision to target size, value and profitability premiums is just a starting point. A myriad of questions come in when you consider how to incorporate these premiums into a real world portfolio. For example:
- How do you weigh the different factors?
- Is it better to get exposure to the premiums by building standalone single factor portfolios and “mixing” them together, overlaying a satellite multi-factor portfolio on a market portfolio, or through an integrated approach that goes overweight on stocks with higher expected returns and vice versa across the entire market?
- How do you capture changing price information every day? (note: price to book, market cap and profitability ratios for each security would change as prices move and companies report earnings)
Dimensional makes deliberate decisions to each of the above questions based on robust research. For example, their research paper “Assessing the Relative Magnitude of Premiums” found “no reliable differences in the expected premiums, either individually or jointly, across US, developed ex-US, and emerging markets” and “no reliable differences across premiums within any region or globally”. This informs the weighting decision across different factors. Dimensional also found that an integrated approach of combining factors, which accounts for the interactions among multiple premiums and maintains a strong tie between security weights and market prices, leads to greater reliability of outperformance, better risk control, and lower costs. This is how they implement their strategies.
Dimensional’s portfolio management team has a daily rebalancing process centred on keeping the strategies consistently focused on the premiums they are intended to capture. While it is important to assess the changing factor exposures on each security and sell down those with lower exposure and purchase those with higher exposure, Dimensional balances such consideration with information on short-term and intra-day expected returns, as well as transaction cost. For example, even if a stock looks attractive on long-term factor exposure, if it is experiencing downward momentum on that day, it has lower short-term expected returns than its peers and it might be better off holding off the purchase temporarily. Such a process reduces unnecessary turnover and allows for a flexible trading approach that enables opportunistic execution and minimises costs.
It is also worth mentioning briefly Dimensional’s process on the fixed-income front. Despite the popularity of factor investing in the equity market, factor investing in fixed income is still catching up in terms of asset size and its availability to retail investors. Dimensional has been managing fixed income assets since 1983 using a systematic approach, and its systematic fixed income strategies are now available for retail investors in Singapore via Endowus.
There are many parallels between the fixed income and equity investing process, including the daily rebalancing process that’s critical in maintaining a continuous focus on higher expected returns efficiently. However, in fixed income, risks can be more clearly defined than equities, and Dimensional has a robust credit monitoring process to potentially exclude securities that are trading at a price that’s markedly lower than its peers, indicating a looming downgrade. This has proved to add value to its process and helped to mitigate unnecessary credit risk.
Continuous innovation is in Dimensional’s DNA and we are encouraged to see the incremental improvements of their process, such as the implementation of the “investment factor” (exclusion of high asset growth stocks in the small-cap universe) in equities strategies, and their foray into lower quality bonds as the data becomes more abundant for systematic managers. Their rigour in research, focus on delivering better results for clients, and transparency in their process, are key pillars that provide us conviction and desire to partner with them on behalf of our clients.
It's important to note that Dimensional always starts with this concept of broad passive exposure to the overall markets in its funds.
Accessing Dimensional’s investment strategies through Endowus Hong Kong
Reasons why Dimensional might still be unknown to many retail investors is because their products are only sold through selected financial advisors, which in turn have to go through a lengthy approval process. And to keep costs low for end investors, DFA does not pay trailer commissions or “kickbacks” to distributors who recommend their funds.
We are delighted to share that Dimensionals’ investment strategies, in Hong Kong for the first time, are now available to retail investors to access through our newly launched Endowus Flagship Portfolios. Endowus Flagship Portfolios are curated by our Endowus Investment Office with the aim to provide clients globally diversified exposure with Best-In-Class Funds at low and fair fees.
Professional Investors can also access Dimensionals’ investment strategies as individual strategies or use them as building blocks to build your own portfolios.
Click here to get started on your wealth journey on Endowus Hong Kong or schedule a free 1-on-1 consultation with our SFC licensed advisors today.
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Risk Warnings
Investment involves risk. Past performance is not an indicator nor a guarantee of future performance. The value of investments and the income from them can go down as well as up, and you may not get the full amount you invested.
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